The U.S. Government Accountability Office recommends that the Securities and Exchange Commission try to ease the implementation burden of internal control reporting rules, rather than just giving small companies a pass on the requirements.

The SEC Advisory Committee on Smaller Public Companies and others have suggested that smaller firms should be exempt from section 404 of Sarbanes-Oxley, regarding internal control reporting, until regulators can come up with a version that better suits small companies.

The GAO recommends that the chairman of SEC, “assess the guidance available, with an emphasis on implementation guidance for management’s assessment of internal control over financial reporting, to determine whether the current guidance is sufficient and whether additional action is needed, such as issuing supplemental or clarifying guidance to help smaller public companies meet the requirements of section 404.”

It also calls on the SEC to coordinate with the accounting industry oversight board to help ensure that section 404-related audit standards and guidance are consistent with any additional guidance applicable to management’s assessment of internal control; and, to identify additional ways in which auditors’ can achieve more economical, effective, and efficient implementation of the standards and guidance related to internal control over financial reporting.

“If, in evaluating the recommendations of its advisory committee, SEC determines that additional relief is appropriate beyond the current July 2007 compliance date for non-accelerated filers, we recommend that the chairman of SEC analyze and consider, in addition to size, the unique characteristics of smaller public companies and the knowledge base, educational background, and sophistication of their investors in determining categories of companies for which additional relief may be appropriate to ensure that the objectives of investor protection are adequately met and any relief is targeted and limited,” it says.

It notes that it has concerns regarding the advisory committee’s recommendations. “While the recommendations hinge on the need for a framework that recognizes smaller public company characteristics and needs of smaller public companies, they do not address what needs to be done to establish such a framework or how such a framework should take into consideration the characteristics and needs of smaller public companies,” the GAO says. “Many, if not most, of the significant problems and challenges encountered by large and small companies in implementing section 404 related to problems with implementation, rather than the internal control framework itself.”

“We believe that sufficient guidance covering both the internal control framework and the means by which it can be effectively implemented is essential to enable large and small public companies to implement a framework which would enable effective and efficient assessment and reporting on the effectiveness of internal control over financial reporting,” it adds.

Also, the GAO warns that if the SEC follows the advisory committee’s recommendations a large number of companies would likely qualify for the proposed exemptions. “If resolution of small public company concerns about a framework and its implementation results in an extended period of exemption, then large numbers of public companies would potentially be exempted for additional periods from complying with this important investor protection component of the act,” it points out.

The categories of microcap and smallcap companies, as defined by the advisory committee recommendations, cover 79% of U.S. public companies and 6% of the U.S. equity market capitalization when combined, it notes.

“Until sufficient guidance is available for smaller public companies, some interim regulatory relief on a limited scale may be appropriate. However, given the number of public companies that would potentially qualify for relief under the recommendations being considered, we believe that a significant reduction in scope of the proposed relief needs to occur to preserve the overriding investor protection purpose of the Sarbanes-Oxley Act,” it says; noting, “Indicators also show that in some respects, smaller companies have a higher risk profile for investors. For instance, smaller public companies have higher rates of restatements generally and showed a disproportionately higher rate of reported material weakness in internal control over financial reporting during the initial year of section 404 implementation.”

“It is essential that SEC consider key principles, under the umbrella principle of investor protection, when deciding whether or to what extent to provide smaller public companies with alternatives to full implementation of the section 404 requirements,” the GAO says.